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Asset Retirement Obligation: Why It’s Important & How to Account for It

Asset retirement obligation is a policy that was started by the Financial Accounting Standards Board, or the FASB, in 2001. Also known as SFAS 143, this statement ensures that companies account for the liability and costs necessary to clean up the location of a lease come the end of the contract.

What is Asset Retirement Obligation?

Asset retirement obligation refers to the legal obligation of a company to clean up any hazardous equipment or materials put on the property at the end of a lease agreement.

Companies under ARO are required to include asset retirement obligations in their financial statements in order to provide a more holistic picture of a company’s overall value to investors and accountants.

Why is Asset Retirement Obligation Important?

ARO and ARO accounting are important because they act as an indicator of the fair value of legal obligation that a company takes on when they change the infrastructure of a lease property. 

Under ARO, companies are required to ensure that they can restore a lease property back to its original state in the initial recognition of the lease, avoiding potential issues down the road.

ARO Accounting

ARO accounting is the accounting that must be performed and included on the financial statements of companies that create physical infrastructure on a land lease which must be dismantled by the end of the lease. Once an asset is removed, it is “retired.”

Actually calculating ARO involves either using fair-market value as a baseline metric, or, if there isn’t one for a certain type of asset, then asking a Certified Public Accountant to estimate your ARO in accordance with Generally Accepted Accounting Principles (GAAP).

Here’s a little step-by-step guide on calculating expected present value of ARO:

  1. Estimate when retirement activities would need to begin and what that allotted cash flow would look like.
  2. Calculate your credit-adjusted, risk-free rate (a firm’s interest rate based on its credit standing).
  3. Make sure to make note of any increases in accretion expenses by multiplying the beginning liability by the credit-adjusted, risk-free rate for when the liability was initially measured.
  4. Make a note of whether liability revisions are trending upward/downward, and then add a discount for the credit-adjusted, risk-free rate or a discount on the reduction at the rate used for the initial recognition of the relevant liability year, respectively. 

When Should I Record my ARO?

ARO accounting should be performed at the initial recognition and measurement of a lease. When the lease ends and an asset is retired, ARO should be derecognized as remediation costs are incurred.

A gain or loss should be recorded at the end of the lease in order to document the difference between the actual cost of ARO and the recorded liabiltiy on a company’s ARO accounting.

Is an ARO a Current Liability?

Because ARO is associated with the retirement of a fixed asset, ARO is a fixed, not a current, liability.

Current liabilities are liabilities due within one year, whereas fixed liabilities are those that are payable over a term longer than a year. Therefore, most leases that have to be GAAP-compliant are fixed liabilities.

Asset Retirement Obligation FAQs

What is ARO and ARC?

Asset retirement cost is related to, but not the same as, asset retirement obligation.

Whereas ARO is the estimated costs of an expense you expect your business to incur after it stops being productive, asset retirement costs are the actual amount it takes to retire an asset. These costs are included as expenses in your financial reports, whereas asset retirement obligations are included as liabilities.

What is Accretion Accounting?

An accretion expense in accounting is created when the present value of a liability is updated (increased or decreased) on a balance sheet.

When it comes to ARO accounting, a company might end up incurring an accretion expense depending on how the cost of removing an asset changes over time.

How to Make ARO Accounting Easier

There’s an easy way to make ARO accounting faster without sacrificing accuracy or compliance: LeaseCrunch software. LeaseCrunch makes every aspect of lease accounting simpler, from updating procedures based on GASB and FASB policy releases, to auto-populating data to avoid errors.

Interested in easing the burden of lease accounting on your business? Contact us today for a free demo.

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